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Sea Isle City 1031 FAQ's
Every
Section 1031 Exchange transaction is
different. These "Frequently Asked
Questions" are intended to answer general
inquiries. The application of these
principles will depend on the specific facts
of each transaction. Always consult a
competent Qualified Intermediary, attorney,
or tax advisor to determine how an exchange
may best be structured to accomplish your
investment objectives.
Q - What is a
tax-deferred exchange?
In a typical transaction, the property owner
is taxed on any gain realized from the sale.
However, through a Section 1031 Exchange,
the tax on the gain is deferred until some
future date.
Section 1031 of the
Internal Revenue Code provides that no gain
or loss shall be recognized on the exchange
of property held for productive use in a
trade or business, or for investment. A
tax-deferred exchange is a method by which a
property owner trades one or more
relinquished properties for one or more
replacement properties of "like-kind", while
deferring the payment of federal income
taxes and some state taxes on the
transaction.
The theory behind
Section 1031 is that when a property owner
has reinvested the sale proceeds into
another property, the economic gain has not
been realized in a way that generates funds
to pay any tax. In other words, the
taxpayer's investment is still the same,
only the form has changed (e.g. vacant land
exchanged for apartment building).
Therefore, it would be unfair to force the
taxpayer to pay tax on a "paper" gain.
The like-kind exchange
under Section 1031 is tax-deferred, not
tax-free. When the replacement property is
ultimately sold (not as part of another
exchange), the original deferred gain, plus
any additional gain realized since the
purchase of the replacement property, is
subject to tax.
Q - What are the
benefits of exchanging v. selling?
- A Section 1031
exchange is one of the few techniques
available to postpone or potentially
eliminate taxes due on the sale of
qualifying properties.
- By deferring the
tax, you have more money available to
invest in another property. In effect,
you receive an interest free loan from
the federal government, in the amount
you would have paid in taxes.
- Any gain from
depreciation recapture is postponed.
- You can acquire and
dispose of properties to reallocate your
investment portfolio without paying tax
on any gain.
Q - What are the
different types of exchanges?
- Simultaneous
Exchange: The exchange of the
relinquished property for the
replacement property occurs at the same
time.
- Delayed Exchange:
This is the most common type of
exchange. A Delayed Exchange occurs when
there is a time gap between the transfer
of the Relinquished Property and the
acquisition of the Replacement Property.
A Delayed Exchange is subject to strict
time limits, which are set forth in the
Treasury Regulations.
- Build-to-Suit
(Improvement or Construction) Exchange:
This technique allows the taxpayer to
build on, or make improvements to, the
replacement property, using the exchange
proceeds.
- Reverse Exchange:
A
situation where the replacement property
is acquired prior to transferring the
relinquished property. The IRS has
offered a safe harbor for reverse
exchanges, as outlined in Rev. Proc.
2000-37, effective September 15, 2000.
These transactions are sometimes
referred to as "parking arrangements"
and may also be structured in ways which
are outside the safe harbor.
- Personal Property
Exchange: Exchanges are not limited to
real property. Personal property can
also be exchanged for other personal
property of like-kind or like-class.
Q - What are the
requirements for a valid exchange?
- Qualifying Property
- Certain types of property are
specifically excluded from Section 1031
treatment: property held primarily for
sale; inventories; stocks, bonds or
notes; other securities or evidences of
indebtedness; interests in a
partnership; certificates of trusts or
beneficial interest; and chooses in
action. In general, if property is not
specifically excluded, it can qualify
for tax-deferred treatment.
- Proper Purpose -
Both the relinquished property and
replacement property must be held for
productive use in a trade or business or
for investment. Property acquired for
immediate resale will not qualify. The
taxpayer's personal residence will not
qualify.
- Like Kind -
Replacement property acquired in an
exchange must be "like-kind" to the
property being relinquished. All
qualifying real property located in the
United States is like-kind. Personal
property that is relinquished must be
either like-kind or like-class to the
personal property which is acquired.
Property located outside the United
States is not like-kind to property
located in the United States.
- Exchange
Requirement - The relinquished property
must be exchanged for other property,
rather than sold for cash and using the
proceeds to buy the replacement
property. Most deferred exchanges are
facilitated by Qualified Intermediaries,
who assist the taxpayer in meeting the
requirements of Section 1031.
Q - What are the general
guidelines to follow in order for a taxpayer
to defer all the taxable gain?
- The value of the
replacement property must be equal to or
greater than the value of the
relinquished property.
- The equity in the
replacement property must be equal to or
greater than the equity in the
relinquished property.
- The debt on the
replacement property must be equal to or
greater than the debt on the
relinquished property.
- All of the net
proceeds from the sale of the
relinquished property must be used to
acquire the replacement property.
Q - When can I take
money out of the exchange account?
Once the money is
deposited into an exchange account, funds
can only be withdrawn in accordance with the
Regulations. The taxpayer cannot receive any
money until the exchange is complete. If you
want to receive a portion of the proceeds in
cash, this must be done before the funds are
deposited with the Qualified Intermediary.
Q - Can the replacement
property eventually be converted to the
taxpayer's primary residence or a vacation
home?
Yes, but the holding
requirements of Section 1031 must be met
prior to changing the primary use of the
property. The IRS has no specific
regulations on holding periods. However,
many experts feel that to be on the safe
side, the taxpayer should hold the
replacement property for a proper use for a
period of at least one year.
If the owner later on
wants to take advantage of the home owner's
exemption (up to $250,000 or $500,000 for a
couple), there is now a five year holding
period requirement.
Q - What is a Qualified
Intermediary (QI)?
A Qualified
Intermediary is an independent party who
facilitates tax-deferred exchanges pursuant
to Section 1031 of the Internal Revenue
Code. The QI cannot be the taxpayer or a
disqualified person.
- Acting under a
written agreement with the taxpayer, the
QI acquires the relinquished property
and transfers it to the buyer.
- The QI holds the
sales proceeds, to prevent the taxpayer
from having actual or constructive
receipt of the funds.
-
Finally, the QI
acquires the replacement property and
transfers it to the taxpayer to complete
the exchange within the appropriate time
limits.
Q - Why is a Qualified
Intermediary needed?
The exchange ends the
moment the taxpayer has actual or
constructive receipt (i.e. direct or
indirect use or control) of the proceeds
from the sale of the relinquished property.
The use of a QI is a safe harbor established
by the Treasury Regulations. If the taxpayer
meets the requirements of this safe harbor,
the IRS will not consider the taxpayer to be
in receipt of the funds. The sale proceeds
go directly to the QI, who holds them until
they are needed to acquire the replacement
property. The QI then delivers the funds
directly to the closing agent.
Q - Can the taxpayer
just sell the relinquished property and put
the money in a separate bank account, only
to be used for the purchase of the
replacement property?
The IRS regulations are
very clear. The taxpayer may not receive the
proceeds or take constructive receipt of the
funds in any way, without disqualifying the
exchange.
Q - If the taxpayer has
already signed a contract to sell the
relinquished property, is it too late to
start a tax-deferred exchange?
No, as long as the
taxpayer has not transferred title, or the
benefits and burdens of the relinquished
property, she can still set up a
tax-deferred Exchange. Once the closing
occurs, it is too late to take advantage of
a Section 1031 tax-deferred exchange (even
if the taxpayer has not cashed the proceeds
check).
Q - Does the Qualified
Intermediary actually take title to the
properties?
No, not in most
situations. The IRS regulations allow the
properties to be deeded directly between the
parties, just as in a normal sale
transaction. The taxpayer's interests in the
property purchase and sale contracts are
assigned to the QI. The QI then instructs
the property owner to deed the property
directly to the appropriate party (for the
relinquished property, its buyer; for the
replacement property, taxpayer).
Q - What are the time
restrictions on completing a Section 1031
exchange?
A taxpayer has 45 days
after the date that the relinquished
property is transferred to properly identify
potential replacement properties. The
exchange must be completed by the date that
is 180 days after the transfer of the
relinquished property, or the due date of
the taxpayer's federal tax return for the
year in which the relinquished property was
transferred, whichever is earlier. Thus, for
a calendar year taxpayer, the exchange
period may be cut short for any exchange
that begins after October 17th. However, the
taxpayer can get the full 180 days, by
obtaining an extension of the due date for
filing the tax return.
Q - What if the taxpayer
cannot identify any replacement property
within 45 days, or close on a replacement
property before the end of the exchange
period?
Unfortunately, there are
no extensions available. If the taxpayer
does not meet the time limits, the exchange
will fail and the taxpayer will have to pay
any taxes arising from the sale of the
relinquished property, unless the IRS
has expressly granted extensions in
specified disaster area(s).
Q - Is there any limit
to the number of properties that can be
identified?
There are three rules
that limit the number of properties that can
be identified. The taxpayer must meet the
requirements of at least one of these rules:
- 3-Property Rule:
The taxpayer may identify up to 3
potential replacement properties,
without regard to their value; or
- 200% Rule: Any
number of properties may be identified,
but their total value cannot exceed
twice the value of the relinquished
property, or
-
95% Rule:
The
taxpayer may identify as many properties
as he wants, but before the end of the
exchange period the taxpayer must
acquire replacement properties with an
aggregate fair market value equal to at
least 95% of the aggregate fair market
value of all the identified properties.
Q - What are the
requirements to properly identify
replacement property?
Potential replacement
property must be identified in a writing,
signed by the taxpayer, and delivered to a
party to the exchange who is not considered
a "disqualified person". A "disqualified"
person is any one who has a relationship
with the taxpayer that is so close that the
person is presumed to be under the control
of the taxpayer. Examples include blood
relatives, and any person who is or has been
the taxpayer's attorney, accountant,
investment banker or real estate agent
within the two years prior to the closing of
the relinquished property. The
identification cannot be made orally.
Q - Are Section 1031
Exchanges limited only to real estate?
No. Any property that is
held for productive use in a trade or
business, or for investment, may qualify for
tax-deferred treatment under Section 1031.
In fact, many exchanges are "multi-asset"
exchanges, involving both real property and
personal property.
Q - What is a
"multi-asset" exchange?
A
multi-asset exchange involves both real and
personal property. For example, the sale of
a hotel will typically include the
underlying land and buildings, as well as
the furnishings and equipment. If the
taxpayer wants to exchange the hotel for a
similar property, he would exchange the land
and buildings as one part of the exchange.
The furnishings and equipment would be
separated into groups of like-kind or
like-class property, with the groups of
relinquished property being exchanged for
groups of replacement property.
Although the definition
of like-kind is much narrower for personal
property and business equipment, careful
planning will allow the taxpayer to enjoy
the benefits of an exchange for the entire
relinquished property, not just for the real
estate portion.
Q - What is a reverse
exchange?
A reverse exchange,
sometimes called a "parking arrangement,"
occurs when a taxpayer acquires a
Replacement Property before disposing of
their Relinquished Property. A "pure"
reverse exchange, where the taxpayer owns
both the Relinquished and Replacement
properties at the same time, is not allowed.
The actual acquisition of the "parked"
property is done by an Exchange
Accommodation Titleholder (EAT) or parking
entity.
Q - Is a reverse
exchange permissible?
Yes. Although the
Treasury Regulations still do not apply to
reverse exchanges, the IRS issued "safe
harbor" guidelines for reverse exchanges on
September 15th, 2000, in Revenue Procedure
2000-37. Compliance with the safe harbor
creates certain presumptions that will
enable the transaction to qualify for
Section 1031 tax-deferred exchange
treatment.
Q - How does a reverse
exchange work?
In a typical reverse (or
"parking") exchange, the "Exchange
Accommodation Titleholder" (EAT) takes title
to ("parks") the replacement property and
holds it until the taxpayer is able to sell
the relinquished property. The taxpayer then
exchanges with the EAT, who now owns the
replacement property. An exchange structured
within the safe harbor of Rev. Proc. 2000-37
cannot have a parking period that goes
beyond 180 days.
Q - What happens if the
exchange cannot be completed within 180
days?
If the reverse exchange
period exceeds 180 days, then the exchange
is outside the safe harbor of Rev. Proc.
2000-37. With careful planning, it is
possible to structure a reverse exchange
that will go beyond 180 days, but the
taxpayer will lose the presumptions that
accompany compliance with the safe harbor.
Q - Can the proceeds
from the relinquished property be used to
make improvements to the replacement
property?
Yes. This is known as a
Build-to-Suit or Construction or Improvement
Exchange. It is similar in concept to a
reverse exchange. The taxpayer is not
permitted to build on property she already
owns. Therefore, an unrelated party or
parking entity must take title to the
replacement property, make the improvements,
and convey title to the taxpayer before the
end of the exchange period.
Q- What is the
difference between "realized" gain and
"recognized" gain?
Realized gain is the
increase in the taxpayer's economic position
as a result of the exchange. In a sale, tax
is paid on the realized gain. Recognized
gain is the taxable gain. Recognized gain is
the lesser of realized gain or the net boot
received.
Q - What is Boot?
Boot is any property
received by the taxpayer in the exchange
which is not like-kind to the relinquished
property. Boot is characterized as either
"cash" boot or "mortgage" boot. Realized
Gain is recognized to the extent of net boot
received.
Q - What is Mortgage
Boot?
Mortgage Boot consists
of liabilities assumed or given up by the
taxpayer. The taxpayer pays mortgage boot
when he assumes or places debt on the
replacement property. The taxpayer receives
mortgage boot when he is relieved of debt on
the replacement property. If the taxpayer
does not acquire debt that is equal to or
greater than the debt that was paid off,
they are considered to be relieved of debt.
The debt relief portion is taxable, unless
offset when netted against other boot in the
transaction.
Q - What is Cash Boot?
Cash Boot is any boot
received by the taxpayer, other than
mortgage boot. Cash boot may be in the form
of money or other property.
Q - What are the boot
"netting" rules?
- Cash boot paid
offsets cash boot received
- Cash boot paid
offsets mortgage boot received (debt
relief)
- Mortgage boot paid
(debt assumed) offsets mortgage boot
received
- Mortgage boot paid
does not offset cash boot received
-
Q
- I bought the property as a single person
and I would like to acquire the replacement
property together with my spouse?
The most conservative
way is to stay consistent and complete the
exchange the same way it was started and to
add the spouse after the completion of the
exchange. An exception can be made if there
is a lender requirement that the spouse has
to be added in order to qualify for a loan.
If an exchange is planned well ahead of
time, another solution would be to add the
spouse to the title of the currently held
property. Timing should be discussed with
the CPA.
Q - I closed escrow on my first replacement
property within the 45 day identification
period. Can I now identify three more
properties within my 45 day identification
period?
If you are using the three property
rule, the completed acquisition counts as
one and you may identify only up to two
additional properties.
Q - How do I
identify two different properties (or
percentages of ownership through a TIC)
covered by ONE purchase contract?
If the properties could be sold
separately at a later date, they should be
identified as two properties.
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